From the IFRS Institute – December 6, 2019
In 2019, only 16%1 of private sector workers in the United States have access to defined benefit plans. Despite the downward trend, employers who still offer those plans grapple with the complexity of the underlying accounting requirements. This can be especially challenging for dual reporters given the differences between IAS 192 and ASC 715.3 Here we provide an overview of defined benefit plan accounting under IFRS Standards, and summarize what we consider to be the top 10 differences between IAS 19 and US GAAP.
Defined benefit vs. defined contribution plans under IFRS
Among employers, there has been a general movement away from defined benefit plans and toward defined contribution plans in recent years.4 In 2019, only 16% of private sector workers in the United States have access to a defined benefit plan, while 64% have access to a defined contribution plan. This is due, in part, to the increasing cost of managing defined benefit plans and higher liabilities associated with such plans because of increases in life expectancy and a reduction in interest rates, not to mention more complex accounting.
Defined benefits plans are employee benefits (other than termination benefits and short-term employee benefits) payable to employees after the completion of employment (before or during retirement). These plans can be funded, meaning the employer sets aside funds to meet its future obligation under the plan. However, the employer’s obligation is not limited to an amount it agrees to contribute to the fund. By contrast, under a defined contribution plan (e.g. 401k plans), an employer makes fixed cash contributions to a fund and has no further obligation to the employee in the event of any shortfall in the fund at the time benefits are due.
4-step accounting for defined benefit plans under IFRS
Step 1: Determine the present value of the defined benefit obligation by applying an actuarial valuation method
The ultimate cost of a defined benefit plan is uncertain and is influenced by variables such as final salaries, employee turnover and mortality, employee contributions and medical cost trends. Therefore, to measure the present value of the defined benefit obligation, entities apply an actuarial valuation method, make actuarial assumptions and attribute benefits to periods of service. IAS 19 mandates the projected unit credit method to determine the present value of the defined benefit obligation and related current service cost.
This method involves projecting future salaries and benefits to which an employee will be entitled at the expected date of employment termination. The obligation for these estimated future payments is then discounted to determine the present value of the defined benefit obligation and allocated to remaining service periods to determine the current service cost. The discount rate is one of the key actuarial assumptions because it can significantly impact the measurement of the defined benefit obligation and subsequent net interest expense.
Step 2: Deduct the fair value of any plan assets
Once the present value of the defined benefit obligation is determined, the fair value of any plan assets is deducted to determine the deficit or surplus.
Step 3: Adjust the amount of the deficit or surplus for any effect of limiting a net defined benefit asset to the asset ceiling
The amount of any deficit or surplus may need to be adjusted for the effect of an asset ceiling, to obtain the net defined benefit liability (asset) to be recognized. An asset ceiling is the present value of economic benefits available in the form of an unconditional right to a refund or reductions in future contributions to the plan. The determination about whether economic benefits are available to the entity requires careful consideration of the facts and circumstances, including the terms of the plan and applicable legislation.
For plan surpluses with an asset ceiling, the asset is measured at the lower of the surplus or the asset ceiling. Plan deficits can also be impacted by asset ceilings if the plan has a minimum funding requirement. For example, if payments under a minimum funding requirement create a surplus, which exceeds an asset ceiling, an additional liability is recognized. Asset ceilings can therefore significantly affect the amount of any surplus or deficit that is recognized and should therefore be carefully assessed.
Step 4: Determine service costs, net interest and remeasurements of the net defined benefit liability (asset)
To be recognized in profit or loss
- Current service cost is the increase in the present value of the defined benefit obligation resulting from employee service in the current period. Generally, current service cost is determined using actuarial assumptions set at the start of the annual reporting period. Similarly, net interest on the net defined benefit liability (asset) is determined using the net defined benefit liability (asset) and discount rate at the start of the annual reporting period.
- Past service cost is the change in the present value of the defined benefit obligation resulting from a plan amendment (e.g. changing the retirement age from 60 to 65) or curtailment (e.g. office closure makes employees redundant). When determining past service cost, IAS 19 requires an entity to remeasure the net defined benefit liability (asset) using the current fair value of plan assets and current actuarial assumptions.
To be recognized in other comprehensive income (OCI)
- Remeasurements of the net defined benefit liability (asset) include actuarial gains and losses, the return on plan assets (excluding amounts included in net interest), and changes in the effect of the asset ceiling (excluding amounts included in net interest), all of which are recognized in OCI. Remeasurements therefore include changes in the net defined benefit liability (asset) attributable to a true-up in actuarial assumptions (differences between actuarial assumptions at the end of the reporting period versus those at the beginning).
How is IAS 19 different from US GAAP?
There are a number of differences between the accounting requirements for defined benefit plans under IAS 19 and US GAAP requirements. Here we summarize 10 of those key differences.
- IAS 19 mandates a specific actuarial method for measuring the defined benefit obligation; US GAAP does not
IAS 19 requires use of the projected unit credit method to estimate the present value of the defined benefit obligation, while US GAAP requires that the actuarial method selected reflect the plan’s benefit formula. Accordingly, if an actuarial method other than the projected unit credit method is used under US GAAP, measurement differences will arise.
- Discount rate selection under IAS 19 and US GAAP can differ
Under IAS 19, the discount rate is determined by reference to market yields on high-quality corporate bonds denominated in the same currency as the defined benefit obligation. If a deep market does not exist (i.e. there are not enough high-quality corporate bonds available), the yield on government bonds denominated in the currency of the defined benefit obligation is used. US GAAP does not include a requirement to use market yields from government bonds absent a deep market. Therefore, the discount rate for a defined benefit plan located in a country without a deep market for high-quality corporate bonds may differ under US GAAP.
Further, US GAAP requires selection of assumed discount rates that are consistent with the manner in which benefit payments are expected to be settled (the ‘settlement approach’). This could include a spot-rate yield curve that is adjusted to exclude outliers, or a hypothetical bond portfolio. IAS 19, on the other hand, does not require use of a settlement approach but instead requires assumptions to be unbiased and mutually compatible. As such, certain methods used to determine discount rates under US GAAP (e.g. a discount rate methodology that does not have a symmetrical approach to excluding outliers) may not be acceptable under IAS 19.
- IAS 19 imposes an asset ceiling; US GAAP does not
IAS 19 imposes an asset ceiling that may restrict the amount of a recognized surplus, or increase a plan deficit. US GAAP does not limit the amount of the net defined benefit asset that can be recognized. Therefore, the application of the asset ceiling under IAS 19 may result in differences from US GAAP related to the amount of the surplus or deficit recognized.
- IAS 19 limits income on plan assets to interest income; US GAAP reflects actual returns
Under IAS 19, the net interest expense consists of interest income on plan assets, interest cost on the defined benefit obligation, and interest on the effect of any asset ceiling. Net interest expense is computed based on the benefit obligation’s discount rate. Differences between the net interest and actual returns are included in remeasurement gains and losses, which are recognized in OCI and are not recycled to net income in subsequent periods but may be transferred within equity (e.g. from OCI into retained earnings).
Unlike IFRS Standards, under US GAAP the expected return on plan assets is based on the fair value of plan assets or calculated value and differences between expected and actual returns are recognized immediately in net income or initially in OCI and subsequently amortized to net income.
Presentation of net interest expense and service cost
IAS 19 does not specify where net interest expense and service cost should be presented or whether such items should be presented separately; as such, an entity chooses a presentation approach that should be consistently applied. In practice, net interest expense is generally presented within net finance expense.
In comparison, following the adoption of ASU 2017-075, all components of net periodic benefit cost, other than current service cost, are now presented outside any subtotal of operating results under US GAAP, if such a line item is separately presented. However, unlike IFRS, US GAAP limits the components that are eligible for capitalization into assets to only the service cost component.
- IAS 19 prohibits recognition of actuarial gains and losses in net income; US GAAP does not
Under IAS 19, actuarial gains and losses are recognized in OCI and are never recycled to net income in subsequent periods but may be transferred within equity (e.g. from OCI into retained earnings).
US GAAP allows entities to recognize actuarial gains and losses in OCI or net income initially. Subsequently, any gains or losses recognized in OCI are recognized in net income under a ‘corridor’ approach. Under this approach, a corridor is calculated at 10% of the greater of the defined benefit obligation or the market-related value of plan assets. Cumulative actuarial gains and losses in excess of the corridor are amortized on a straight-line basis to net income over the expected average remaining working lives of plan participants.
- Plan amendments: Timing of recognizing expense (income) differs
Under IAS 19, the effect of a plan amendment is included in the determination of past service cost and is therefore recognized in net income at the earlier of when the amendment occurs or the related restructuring costs or termination benefits are recognized. Under US GAAP, prior service cost related to a plan amendment is recognized in OCI at the date of the amendment and amortized as a component of net periodic cost in future periods.
- Plan settlements: Measurement of the gain or loss may differ
For defined benefit plan settlements, IAS 19 requires that a settlement gain or loss is generally measured as the difference between the present value of the defined benefit obligation being settled and the settlement amount. Under US GAAP, the settlement gain or loss is the difference between the present value of the defined benefit obligation being settled and the settlement amount, plus a pro rata portion of previously unrecognized actuarial gains and losses. Therefore, the settlement gain or loss under IAS 19 will differ from the US GAAP amount if there are unrecognized actuarial gains and losses under US GAAP.
- Plan curtailments: Both measurement and timing of recognizing the gain or loss may differ
Under IAS 19, a plan curtailment gives rise to a past service cost, which is recognized at the earlier of when the curtailment occurs or when the entity recognizes the related restructuring costs or termination benefits. Under US GAAP, curtailment losses are recognized when they are probable while curtailment gains are recognized when they occur.
From a measurement perspective, curtailment gains and losses under IAS 19 are based on changes in the benefit obligation. Under US GAAP, such gains and losses reflect the increase or decrease in the benefit liability that exceeds the net actuarial gains or losses, in addition to any unrecognized prior service costs no longer expected to be incurred. Any actuarial gains or losses or prior service cost not yet recognized in net income under US GAAP would therefore result in a measurement different from IAS 19.
- Annuity (insurance) contracts may not always be accounted for similarly
Annuity contracts may be held by the plan or by the entity. If the annuity contract is held by the entity, it is treated as a plan asset under IAS 19 if certain conditions are met. These conditions are that the plan is not issued by a related party, and the proceeds of the plan:
. can be used solely to pay or fund defined benefit obligations;
. are not available to creditors, even in the case of bankruptcy; and
. cannot be returned to the entity except as reimbursement for employee benefits paid or when the proceeds are surplus to the requirements.
US GAAP applies the same criteria to determine if annuity contracts should be treated as plan assets. However, unlike IAS 19, under US GAAP annuity contracts can only be plan assets if they are held by the plan. If the annuity contract is held by the entity, it is accounted for under the guidance for investments under the insurance contracts guidance.
- Multi-employer plans are defined contribution plans under US GAAP; not always under IAS 19
Multi-employer plans are plans that pool the assets contributed by various entities (not under common control) to provide benefits to employees of those entities. IAS 19 requires consideration of the underlying characteristics to determine whether it should be classified and accounted for as a defined benefit or defined contribution plan.
Under US GAAP, multi-employer plans are accounted for in a manner similar to defined contribution plans with related disclosures. Any multi-employer plans that are classified and accounted for as defined benefit plans under IAS 19 will have a different treatment under US GAAP.
Accounting for defined benefit plans is not straightforward. While defined benefit plans can be structured similarly in the US and outside of the US, their accounting and presentation can significantly differ between IAS 19 and US GAAP. In addition, when the actuarial valuations are outsourced, management still is responsible for the overall accounting. Therefore, dual reporters need to understand their actuaries’ experience and background, making sure that they have adequate knowledge of these GAAP differences.